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Central Banks Can Plan Smooth Exit From Policies to Fight Crisis

Unconventional central bank policies in some advanced economies have been beneficial for global economy

Central banks have tools to limit financial market volatility, exit may still be bumpy

IMF analysis can help global policy collaboration

Central banks have the tools to limit volatility from an exit from the unconventional monetary policies that helped the global economy begin to recover after the financial crisis in 2008. But some market reactions remain beyond the control of central banks, and the exit could still be bumpy at times.

Policymakers in countries using unconventional monetary policy can counter volatile financial markets with clear communications about their exit plans, according to the IMF.

In a speech at the end of August in Jackson Hole, Wyoming, IMF Managing Director Christine Lagarde said central bank policies have bought global policymakers the time and space to carry out the reforms needed to lay the foundation for lasting growth.

This new work from the IMF takes stock of unconventional monetary policies and focuses on their global impact so far, and looks ahead towards exit and prospects for global policy collaboration.

“Exit from unconventional monetary policy will lead to some normal market adjustments, but there could be additional volatility due to market reactions beyond the control of the central bank,” said Karl Habermeier, an Assistant Director in the IMF’s Monetary and Capital Markets Department. “This volatility could have significant spillovers to the rest of the world, with risks to macroeconomic and financial stability. Countries with stronger macroeconomic and policy fundamentals should cope better with market turbulences.”

Both advanced and emerging economies have benefitted from the use of unconventional monetary policies in some advanced economies.The picture is clearer for early policies to support financial markets functioning and intermediation. A severe financial sector meltdown and a major recession in advanced economies would have had dire consequences globally.

The strong outward capital flows generated by accommodative monetary policies, which contributed to some useful rebalancing of global demand, have also given rise to policy challenges in recipient countries.

The IMF research concludes countries have managed these changes well in the period up to the U.S. Federal Reserve’s first tapering announcement in May 2013. Case studies of 13 of the largest countries that did not use unconventional monetary policies find that none of these countries had exhibited wide-spread or acute economic or financial instability, including as a result of capital inflows, during the period in question.

However, these countries differ considerably in their measured exposure and resilience. “Exposure” refers to the likelihood of market volatility and capital outflows in a given country following exit from unconventional monetary policies. And “resilience” captures the ability of a country to withstand potential market volatility and capital outflows. The more developed economies (Australia—higher resilience, as well as Canada—lower exposure) as well as other emerging economies with higher resilience and/or lower exposure are expected to fare relatively well following a U.S. exit. Some other countries appear more vulnerable due to both higher exposure and lower resilience.

Exit challenges

Economic data and developments should be the factors that determine when and how to start phasing out unconventional monetary policies, according to the IMF.

Exit could be bumpy, with increased volatility in long-term interest rates.Potential reasons for this volatility are:

• uncertainty about the future path of policy rates;

• uncertainty about the ability of central banks to perfectly control short-term market rates during exit in an environment of substantial excess liquidity; and

• uncertainty about the effects of asset sales on prices.

The primary tool to contain potential instability is clear communication. Forward guidance is one component of a communication strategy.

The Federal Reserve and the Bank of England have recently defined the economic thresholds, such as the rate of unemployment, which will determine a change in their monetary policy. This has prepared financial markets for incremental adjustments as the economy grows. There is the possibility that policymakers will have to reconsider these thresholds depending on the pace of economic recovery.

Actions to promote an orderly exit should help counter global disruptions in financial markets, although there could still be significant effects on the rest of the world.

Even if the exit from unconventional monetary policies is well managed, countries can expect some reversal of capital flows, weaker currencies, higher borrowing costs, and further volatility.

Need for global policy collaboration

International policy collaboration may help to improve how countries react to each others’ changes in policy.Given the degree of interconnectedness of today’s economies and financial markets, spillovers, both good and bad, are inescapable.

For example, unconventional monetary policies may have negative effects, such as excessive capital inflows in countries not using the policies. In turn these countries might take capital flow measures to offset the effects, resulting in financial losses in countries using unconventional monetary policies. International policy collaboration can in principle lead to improved economic outcomes globally.

The IMF can help oil the wheels of economic cooperation and collaboration. IMF analysis can provide an independent and rigorous approach to exploring spillover effects—both positive and negative—of policies. In addition to IMF research that focuses on unconventional monetary policy issues, regular IMF surveillance of countries’ economic health can help illuminate the underlying issues involved in unconventional monetary policies. Multilateral products such as the World Economic Outlook and Global Financial Stability Report provide a global perspective on the two main issues associated with these policies: prospects for growth and for financial stability.

In addition to discussions at the IMF, such analysis can provide a global perspective to other forums where policy cooperation is on the agenda. IMF lending facilities also provide an avenue for preventing and alleviating some of the risks from unconventional monetary policies.

The IMF Survey welcomes comments, suggestions, and brief readers' letters, a selection of which are posted under What readers say. Letters may be edited. Please address Internet correspondence to imfsurvey@imf.org.